Tobias Carlisle: How to Find Deep-Value Investments

For 10 chapters in "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," author Tobias Carlisle has been telling readers about the advantages of deep-value investing, using a metric called the Acquirer’s Multiple.

This metric uses enterprise value and operating earnings to find stocks with hidden or “hidden in plain sight” assets in financial statements. It can also be used to identify hidden value traps.

So where can an investor find stocks where assets exceed the currently depressed share price? It begins by acknowledging that if you buy the market, you will get average returns. If you want to beat the market, then you must do something different. Something different means buying only undervalued stocks and waiting for reversion to the mean.

It also means being a contrarian, zigging when the crowd is zagging. And, that’s not easy because we are hardwired to follow the crowd, rather than run against it. Carlisle wrote, “Following the trend is instinctive. Mean reversion is not. But the data show mean reversion is more likely.” He also noted there are several consequences for investors:

• Value matters more than the earnings trend. Mean reversion leads to cheap stocks becoming more expensive while expensive stocks get cheaper.
• Low or no-growth stocks eventually beat high-growth stocks—mean reversion affects growth as well as valuations.
• Undervalued, low-profit stocks will outperform high-profit stocks.

Carlisle added that highly-profitable stocks only beat the market if they have moats that protect margins and profits.

With that, Carlisle turned to the need for simplicity in investing. He pointed out many social scientists have compared the forecasts of experts against simple rules. And, with rare unanimity, the studies concluded simple rules do better than the experts. For value investors, only a couple of simple rules are usually needed:

• Buy only when the price is well below a stock’s intrinsic value.
• Sell when the price is well above the stock’s intrinsic value.

Along with those rules came the assumption an investor will use the same strategy every time, whether it is the Acquirer’s Multiple, the Magic Formula or some other approach. Of course, it’s not easy to stick to a strategy; we all want to be experts and bend the rules a bit. As Carlisle wrote:

“Many investors hate strict rules. They think it’s better to use the output from the simple rule and then decide whether to follow it. This isn’t a bad way to go. Experts make better decisions when they use simple rules. But they don’t do as well as the simple rule alone.”

His website offers four screeners for finding undervalued stocks, one free and three behind a subscription paywall. This screenshot, from the free dataset, shows the five (out of 30) most undervalued large-cap stocks on the list at mid-day on Feb. 27, based on their Acquirer’s Multiples (enterprise value divided by operating earnings). The lower the multiple, “the more value you get for the price you pay and the better the stock”:

Carlisle recommended investors buy at least 20 of the companies on the list to diversity their portfolios, a recommendation more suited to institutional investors than individuals.

He went on to argue there are two basic approaches to using screeners: A quant investor’s perspective and a business owner’s perspective.

Quant investors:

• Use screeners to assemble a portfolio.
• Depend on the performance of the portfolio as a whole.
• Buy top stocks in the screener “without fear or favor.”
• Disregard the problems of any specific stock in the portfolio.
• Take a long-term portfolio approach to beating the market.

Business owners:

• Use the screener to create a universe of potential purchases.
• Analyze the stocks as businesses, as fundamental investors would.
• Buy stocks with margins of safety they like.
• Ignore the portfolio approach.

Carlisle observed these are equally valid approaches, but the business owner approach is more difficult because of the qualitative decisions required. He added most investors would be better off as quantitative investors since all they need to do is follow simple rules. Further, he wrote, “The reasons most people lag the market: cognitive biases and behavioral errors.” That includes the 80% of professional investors who fail to beat the market.

In supporting this conclusion, the author cited a Joel Greenblatt (Trades, Portfolio) article. The latter found investors had trouble executing his Magic Formula, another relatively simple, rule-based selection process.

Greenblatt gave his clients two ways to invest in U.S. stocks, one was the approach of a business owner and the other was the approach of a quant investor. In the business owner-type account, investors picked which top-ranked stocks to buy and sell, and when to make trades. In the quant investor-type account, investors opted for a hands-off, systemic process to make the buy and sell decisions for them.

In an experiment, Greenblatt had both sets of investors pick from the same list of stocks. Over two years, the business owner accounts averaged 59.4% after expenses. A good return, but not as good as the S&P 500, which rose 62.7% over the same period.

The shocker was the quant investor account with an 84.1% return over the same two years, beating the business owner account by nearly 25 points. Greenblatt concluded, “The people who ‘self-managed’ their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!” He added, “I like the message it appears to send—simply, when it comes to long-term investing, doing ‘less’ is often ‘more.’”

In summary, Carlisle again made the point the Acquirer’s Multiple is an effective tool for finding undervalued stocks, this time with an emphasis on following a set of simple rules and on taking a portfolio approach rather than stock-by-stock choices.

Disappointingly, he did not provide guidance for individual investors who cannot afford to buy 20 different stocks at a time. While he argued for many stocks in a portfolio, he failed to consider the collective costs of the stocks and the transactional fees.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

• Tobias Carlisle: Activists Take on Agribrands and Apple
• Tobias Carlisle: Carl Icahn and Deep-Value Investing
• Tobias Carlisle: How Deep Value Produces Outstanding Results